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Terms of engagement

Most ethical or socially responsible funds consider responsible forestry practices to be important. By contrast, the seemingly endless raft of stakeholder pension legislation appears to have become a means by which we can rid the planet of trees. It may seem surprising then that these two could have anything in common.

However, from July 2000, new legislation req uires the trustees of occupational pension schemes to consider their approach to ethical issues and disclose their stance – if any – in their statement of investment principles. From April 2001, the same legislation will apply to the trustees or managers of stakeholder pension schemes.

The story so far is that, to date, company pension schemes and ethical investment have not tended to mix. Unless a company was blatantly ethical, many IFAs have tended not to recommend ethical funds to them and, for the most part, trustees of the UK&#39s biggest pension schemes have been no different. For trustees, ethical investment meant screening, screening meant avoiding companies and avoiding companies was unpopular because of its possible impact on performance.

The fact that we are all more concerned about environmental and social issues now does have a role to play but it is the July rule change that has been the real catalyst for change.

Today most life offices have an ethical fund but the old dilemma for advisers and trustees is unchanged as screened ethical funds are appropriate for many, but not all investors.

This dilemma has led to a shift in the market and an increase in the popularity of the term socially responsible investment or SRI, which is commonly considered to have a wider remit than ethical investment. Ethical investment is regarded as primarily focusing on screening, where possible investments are compared against negative and positive ethical criteria and approved or rejected accordingly. SRI is considered to include any responsible or ethical approach that is applied to an investment strategy.

Both views are borne of the same ideals but SRI has diversified beyond the screened approach to meet the various needs of the different markets. The new engagement-only approach represents the opposite end of the ethical spectrum from screened investment as engagement-only has no impact on investment processes. Engagement-only – or responsible engagement as it is often called – employs company dialogue as its only ethical tool. The aim is that major shareholders can use their position as part owners of the companies in which they invest to encourage companies to behave more responsibly with regard to environmental or social issues.

Screened ethical funds have been well documented over the last 16 years but responsible engagement is new to the UK. It was pioneered here in 1999 by Friends Ivory and Sime, the fund management arm of the Friends Provident Group. It now applies to most of Friends Provident investments under a policy called responsible engagement overlay – the name reflects the idea that the policy overlays but does not alter a conventional investment strategy.

Responsible engagement is winning favour with pension schemes because there is no screening involved and this has been documented in recent research by both ERM and UKSIF. It is also expected to have wide public appeal. Research commissioned by FIS/NOP in June 2000 showed that 74 per cent of the pension scheme members want their pension schemes to encourage socially responsible behaviour by companies.

A combination of these areas of research indicates that stakeholder schemes may indeed be keen to adopt responsible engagement.

Responsible engagement gives funds an ethical angle but does not turn them into ethical funds. Responsible engagement concentrates on mainstream issues because it is designed to have mass-market appeal. Effort is also focused around trying to influence companies in ways that are consistent with improving shareholder value, albeit often over the longer term.

For instance, there is no point asking a company to put its future at risk – first because it would almost certainly refuse, and second because if it did, the fund manager&#39s own investment performance could suffer. Far better, therefore, to focus on potential win-win targets such as where a company&#39s reputation could be damaged if a situation is not well managed, for example, environmental or labour standards issues or deforestation.

Stakeholder schemes are likely to want to tap into this new approach and it is probably worth taking a few steps back before explaining why.

The 1995 Pensions Act requires all pension schemes to have a statement of investment prin ciples, with one notable exemption. If a scheme is fully insured (100 per cent invested in life office funds) it does not need to have such a statement. However, stakeholder pension schemes are an exemption to this exemption.

This means that if a scheme is to be registered under the stakeholder rules it must have an SIP, even if it is fully insured. Stakeholder trustees or managers must, therefore, always disclose the scheme&#39s position with regard to social, ethical and environmental issues.

This means that anyone advising on stakeholder arrangements will have to know about SRI and should be able to describe both screened funds and the lesser spotted engagement-only route offered by some fund providers.

The way the scheme is set up will dictate the level of advice that will be required.

If a scheme is to be stakeholder-compatible but not stakeholder-registered, the SIP requirement will not apply. However, if a scheme is to be registered at a later date (assuming it is able to do so), it may be prudent to consider the SIP rules at an early stage.

If a scheme is set up as a contract-based arrangement, which is likely to be the majority of schemes, then it is up to the life office to provide the SIP. And the wording is its responsibility. But an adviser will need to be confident that the SRI approach described within the SIP is appropriate for their clients, in particular, if SRI-related issues are important to the company or any of the members.

Trust-based schemes are different because the scheme appoints its own trustees and they are responsible for the wording of the SIP. They may want to say as little as possible about social, ethical and environmental issues. Alternatively, they may be keen to disclose their approach fully in the SIP so the document is self-explanatory when issued to members.

The new disclosure requirement means that advisers offering stakeholder schemes will have to give advice on SRI. Responsible engagement is intended to be a straightforward additional ethical solution for schemes and so far this route has been extremely well received. Our next challenge is to make stakeholder more forest-friendly.

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